From Arm's Length to Arm in Arm: Banks and Municipal Bond Financing

Abstract

This paper provides the first detailed examination of banks' municipal bond portfolios using novel regulatory data. We present causal evidence that relationships significantly influence banks' municipal bond investment decisions. Our results challenge the view that issuers and banks derive minimal benefits from relationships in arm's length transactions. Banking relationships benefit local governments by enhancing issuance characteristics in good times and acting as stabilizers during crises. For banks, these relationships provide a substantial informational advantage, leading to superior investment performance. Our findings highlight the unexpected importance of banking relationships in municipal markets and their role in market stability and resilience.

Keywords: Banking relationships, municipal bonds, financial constraints, municipal debt

JEL Classification: G12, G18, G21, G28, H74